We are only just beginning to understand the ramifications of the retail trading boom.
Take Robinhood, which had a lackluster debut. Its shares dropped 8% on their first day of public trading. But on Aug. 4, just a few days after the IPO, options contracts linked to the company’s stock became available, and the shares took off like a rocket.
As many have speculated, the options did play a role in the roller coaster rally that followed—but probably not for the reason some traders think, especially if they haven’t accounted for changes in how trading firms hedge meme stocks.
How market makers usually hedge options contracts
Options, or contracts to buy or sell a particular stock if it changes hands at a certain price, have become wildly popular with the retail investors, including Robinhood customers, because they offer a cheap way to bet on stock prices.
Conventional wisdom is that the mere availability of these derivatives linked to Robinhood’s stock gave the shares a boost thanks to market makers, or companies that post bids and offers for stocks and derivatives (they’re the intermediaries most investors trade with). The thinking is that market makers in call options for Robinhood stock (a bet that the equity will increase in price) will also buy the company’s stock as a hedge, driving up the share price. This type of trade, known as delta hedging, neutralizes the risk of price fluctuations for the market maker.
But that’s not what happens these days in highly erratic meme stocks, according to two options experts interviewed by Quartz.
Meme stocks behave differently
When it comes to meme stocks—powered by online sentiment on platforms like Reddit or Twitter and exemplified by GameStop and AMC Entertainment—market makers using this form of hedging can get burned, the options experts said. That’s because these stocks have broken down the typical relationship between options and the underlying stock.
Part of an option’s price is calculated based on its implied volatility, or a trader’s guess as to the likelihood that a stock’s value will change. When a stock price goes up, its implied volatility typically goes down. This makes a rough sort of sense—if a stock is going up, in theory it’s because investors have more certainty about its future cashflows and profits.
Meme stocks flip this around: The equity may shoot up in price, but it’s reasonable to expect that this price increase is highly unstable. During a trading battle between retail investors and hedge funds, shares of GameStop skyrocketed in January to more than $300 from about $30 a few weeks earlier. It was reasonable to expect that the record high stock price might come crashing down. (Or it could shoot up even higher—there was little or no way to guess what the price would do.) The implied volatility arguably got more unstable as the price went up.
As one of the options experts we spoke with explained, this places market makers in a dangerous position: Imagine a market maker has sold a put on Tesla shares (a bet that the stock will decline in price) and likewise placed a short sale (a bet on the shares to decline) on actual Tesla shares to offset, or hedge, that position. If the shares jump in price, the market maker will lose money on the stock’s short sale. Ordinarily, the options price might be expected to compensate. But if the meme phenomenon is taking place, the put option may, for example, stay at a steady price. Because of the implied volatility input in the option price, the neutralizing hedge has broken down and the trader can lose money. For call options, the situation is basically reversed.
To put things more simply, when it comes to meme stocks, the shares can’t be counted on to offset the gains or the losses on an option. This type of breakdown has happened in several stocks, including AMC, BlackBerry, Tesla, and GameStop. Market makers know this and have adjusted accordingly.
A market maker’s hedge for an option on a meme stock is another option—if it needs one at all
“Meme stocks are completely idiosyncratic—there is no natural hedge,” said Steve Sosnick, chief strategist at Interactive Brokers. ”What’s the hedge for AMC when it’s going insane?”
The large market makers are much more likely to hedge these positions with other options than with the underlying stock. “The best hedge for a call you sell is buying another call,” said Sosnick, who was previously a trader at Morgan Stanley, Lehman Brothers, and Salomon Brothers. “If you buy another call, you’re hedging the volatility risk as well.”
Meanwhile, a particularly large market maker may be able to hedge much of its portfolio with natural order flow, meaning it doesn’t have to buy or sell so much for hedging, another options expert told Quartz. Executives at Virtu Financial, a mega-market maker, said essentially the same thing in an Aug. 4 earnings call when explaining the trading company’s push into options: As a large market maker in US equities, CEO Doug Cifu said, “[w]e have the delta hedge in all these products.”
Robinhood was rallying on a flawed theory
Though the conventional wisdom—that market makers will buy up shares as a hedge for the options they’re dealing in—isn’t accurate, it’s still probably driving the market.
Which is to say, if enough traders are willing to pay higher prices for a stock like Robinhood because of its options activity, then the hedging theory will work because people in the market seem to believe it’s happening, even if that thinking is based on a flawed understanding of what’s taking place.